Lecture 7

Dr. Shoaib Ahmed

 Maximizing profits is a firm’s goal
Economists assume that the overriding goal of all
business enterprises is to make as big a profit as
possible. Economists make this assumption for
two reasons:
• If you ask around, profit maximization is near
the top of every firm’s “to do” list.
• No matter what other goals a firm may have, it
still wants to maximize profits after taking steps
to achieve those other goals.
Maximizing profits is a firm’s goal (Cont’d)
Many non-economists object to people earning profits, but profits
ensure that firms receive crucial contributions of
entrepreneurships and risk-taking. (Earlier, I explained why I think
entrepreneurship is a fourth factor of production along with labor,
land and capital). Think of someone who has the opportunity to
start her own business. She could keep working for someone else
and receive a steady wage. What is her incentive to strike out on
her own and risk starting a business that may fail? The incentive is
that she will receive the profits if the business does well. Without
potential profits, no one would risk leaving a safe job in order to
innovate, consumers as a whole would be hurt because the supply
of great new products and services would come to a halt.
 Facing competition
Firms may or may not face a lot of competition from other
firms. At one extreme lies monopoly, in which a firm faces
no competition because it’s the only firm in its industry. At
the other extreme lies what economists call perfect
competition, a situation in which a firm competes against
many other firms in an industry in which they all produce an
identical good. And in between the extremes lie two
situations: oligopoly, where there are two, three, or at most
a few firms in an industry; and imperfect (monopolistic)
competition, in which there are many competitors, but each
produces a slightly unique good.
 Listing the requirements for
perfect competition
Perfect competition assumes four things about the firms in
the industry:
There are many of them. New firms can freely enter and
existing firms can freely leave purely competitive market.
Each of them represents a very small part of the industry.
Individual Firms exert no significant control over product
price.
Purely competitive firms produce a standardized (identical
or homogeneous) product.
 Perfect Competition (Cont’d)
Wheat farming is an example of an industry that satisfies each of the three criteria.
There are literally tens of thousands of wheat farmers in the United States. None of
them produces more than a small percentage of the total wheat produced each year.
And all of their wheat is basically Identical.
To see why these things together mean that individual farmers have no control over
the price of wheat, start with the fact that the farmers are producing a nearly
identical product. Because the wheat from one farm looks like the wheat from any
other farm, the only way a Kansas wheat farmer can entice me to buy from him
rather than from a Texas wheat farmer is to offer me a lower price. Because all the
wheat is identical, all I care about is price, meaning that farmers have to compete on
price and price alone. With price jumping to the fore as the key factor in the wheat
market, we can use supply and demand analysis to figure out what the price will be.
As I described earlier, the price is determined by where the market demand curve for
wheat crosses the market supply curve for wheat.
If every player is too small to cause the market price to change, then each one has to
take as given whatever price is generated by market demand interacting with market
supply.
 Acting as price takers but quantity makers
• If the three assumptions of perfect competition as mentioned earlier
are met, they produce a situation in which individual firms have no
control over the prices they can charge. In fact, under perfect
competition , firms are referred to by economists as price takers
because they have to take the price as given and deal with it.
• When you come right down to it, even the most powerful firm can
hope to control only two things; how much of its product to make
and what price to charge ? The only thing that price – taking firms
can control is how much to produce.
• Firms choose to make whatever quantity maximizes their profits. This
fact is mathematically convenient because it turns out that the
quantity of output that firm chooses to produce controls each of the
two things that determine profits: total revenues and total cost.
 Acting as price takers but quantity makers
(Cont.)
• To see this fact more clearly, you have to know that a firm’s profit is simply
defined as its total revenue minus its total cost. Put into math,
Profit= TR – TC (1)
Where TR stands for total revenue, and TC stands for total cost.
• For a competitive firm , its total revenue is simply the quantity, q, of its output
that it chooses to sell times the market price, p, that it can get for each unit:
TR= p × q (2)
For instance if I can sell apples for $1 each and I sell 37 apples, my total revenue
is $37.
But notice that because the price at which I can sell (p)is out of my hands if I am
a price taker, The only way I can control my total revenue is by deciding how
many apples to sell. So a firm can determine its total revenue by its decision
about how big or small to make q.
 Acting as price takers but quantity makers
(Cont’d).
• Much of the rest of the things here is devoted to
showing you that the firms total cost, TC, are also
determined by how big or small q is. But the interesting
thing here is that while each extra unit of q sold brings
in a revenue of p dollars, the cost of each unit of q
manufactured depends on how many units of q have
already been made. Costs tend to increase as firms
produce more and more , so each successive unit costs
more than the previous unit. This fact ends up limiting
the number of units that a firm wants to produce.
 Acting as price takers but quantity makers
(Cont’d).
• Consequently, you can see that both the TR and TC
terms in profit equation (1) are determined by the
firms choice of q . The only thing left to figure out is
exactly how big to make q in order to maximize
profits. There is a simple formula that gives the
solution . Before we get to the formula we need to
clarify a major source of confusion caused by the
fact that when economist say the word profit , they
mean something slightly different than what normal
people mean.
 Distinguishing between accounting profits
and economic profits.
• To an economist, the terms profit and loss
refer to whether the gains from running a
business are bigger or smaller than the costs
involved. If the gains exceed the costs, you’re
said to be running a profit, whereas if the
costs exceed the gains, you’re said to be
running a loss. If the two are just equal, you’re
said to be breaking even.
 Taking account of opportunity costs
• Consider a business that sells lemonade. Both the accountant and
economist agree that the firm’s revenues are simply how much
money it makes from selling lemonade. However, they differ on
what to count as costs:

• The accountant considers costs to be only actual monies spent in

running the business: how much the firm pays its workers, how
much it pays to buy lemons, and so on. If the farm has revenues of
$10,000, and it spends $9,000 to make those revenues, the
accountant concludes that the firm has a profit of $1,000. This
number is the firm’s accounting profit-the type of profit that is
reported every day in financial statements and newspaper articles.
Taking account of opportunity costs (Cont’d)

• Economists prefer a more subtle concept that they refer

to as economic profit. Economic profit takes into account
not just the money costs directly incurred by running a
business but also the opportunity costs incurred.
• As I explain earlier opportunity costs are what you have
to give up in order to do something. Think about the
entrepreneur who starts the lemonade business. After
paying for his materials and for his employee’s wages, his
accounting profits are $1000. But is that really a good
deal?
Taking account of opportunity costs (Cont’d)
• Suppose that this person left a job as a computer
programmer to open up the lemonade business, and in
the same amount of time that it took the lemonade
business to turn a $1,000 profit, he would have made
$10,OOO in wages if he had stayed at his old job. That is,
he gave up the opportunity to earn $10,000 in wages to
open up a business that makes him only a $1,000
accounting profit. He actually sustains an economic loss
of $9,000. When you know this fact, his decision to
switch careers doesn’t seem like such a good idea.
 Being motivated by economic profits
• Economists like to concentrate on economic profits and
losses rather than accounting profits or losses because the
economic profits and losses are what motivate people.
• Whenever you see any costs listed, assume that they are
economic costs; that is, they include not only money
directly spent operating a business but also the costs of
other opportunities foregone in order to operate the
business. Likewise whenever you see a profit or loss,
assume that it’s an economic profit or an economic loss-
the factor that motivates entrepreneurs to want to do
something or to avoid doing it.
Being motivated by economic profits Contd..

• The most important application of this concept is to

determine how much output a firm should produce. If
producing the 12th unit of a product produces an
economic profit, obviously the firm wants to produce it.
But if increasing production to a 13th unit would result in
an economic loss, obviously the firm doesn’t want to
produce it.
• By taking into account economic profits and losses, you
get directly at what motivate firms to produce not only
the types of goods they choose to produce, but the
quantities of those goods as well.
 Analyzing a Firm’s Cost Structure
• To see how costs and revenues interact to determine
economic profits or losses, economists like to breakup a
firm’s total costs into two subcategories :
• Fixed costs are costs that have to be paid even if the firm is
not producing anything.
• Variable costs are costs that vary with the amount of
output produced.
• Fixed costs can be represented as FC and variable costs as
VC . Together, they sum up to a firm’s total cost, or TC :
TC =FC + VC …………………………(3)
 Analyzing a Firm’s Cost Structure Contd.

• As you look at equation (3) placed in the previous

slide, keep in mind that it deals with the economic
costs facing the firm and therefore captures the
opportunity costs of the firm’s expenditures on both
fixed costs and variable costs.
• All expenditures , whether they are fixed costs or
variable costs, involve opportunity costs- - the other
things you gave up buying in order to spend the
money you spend on your fixed and variable costs.
Focusing on costs per unit of output
Focusing on costs per unit of output (Cont’d)

(Follow the table above)

When LemonAid Corporation gets started, it buys a juicer
machine for $100, which gives it fixed cost of $100. It then
has to decide how much to produce, which in turn
determines how many workers it needs to hire. In the first
column, the number of workers varies from zero to eight.
If the firm hires no workers, you can see in the top entry of
the second column that no output is produced. But if it
hires workers, output increases as you move down the
second column. More workers mean more output.
 Studying increasing and decreasing returns
But pay attention to the fact that the amount of additional, or marginal,
output produced by each additional worker is not constant. That is, if you go
from no workers to one worker, output increases from nothing to 50 bottles of
lemonade. However, as you go from one worker to two workers, output
increases from 50 bottles to 140 bottles. Put into economic jargon, the second
worker’s marginal output is 90 bottles, whereas the first worker’s marginal
output is only 50 bottles.
Now look at these facts in terms of costs and benefits. If you have to pay each
worker the same wage of $80 per day ($10 per hour for 8 hours of work), you
are going to like the fact that while the first worker produces 50 bottles for his
$80 pay, the second worker produces 90 bottles for his $80 pay.
Economists refer to the situations like this as increasing returns because the
amount of return you get for a given amount of input (one more worker)
increases as you add successive units of input.
 Studying increasing and decreasing returns
contd.
But if you look further down the second column, you find that increasing
returns don’t last forever.
Indeed, in the case of LemonAid Corporation, increasing returns end almost
immediately. Consider what happens to output when you add a third worker.
Output does increase, but only by 80 units, from 140 bottles to 220 bottles.
And things get even worse the more workers you add. Adding a fourth
worker increases output by only 70 bottles, and adding a fifth increases
output by only 60 bottles.
Economists call situations like this diminishing returns because each
successive unit of an input, like labor, brings with it a smaller increase in
output than the previous unit of input. The same holds true for all successive
workers ; having them is helpful, but each one adds less to output than the
previous one because things start getting crowded and there really is not
much room left for improvement.
Fig 10.1:LemonAid’s average variable costs, average fixed costs, and average total
costs.
 Examining average variable costs
• (Follow the above Table 10-1 & Figure 10-1)
• Variable costs are affected by the fact that additional workers first
bring increasing returns but then decreasing returns. In the case of
the LemonAid Corporation example in Table 10-1, the variable costs
are all labor costs, with each worker having to be paid $80 per day.
You can see these variable costs increase as you move down the fifth
column.
• But what’s much more interesting is looking at average variable costs
(AVC), which are defined as variable costs divided by quantity (VC/q).
For instance, because one worker produce 50 bottles of output at a
variable cost of $80, the average variable cost is $80/50=$1.60 per
bottle. When two workers together cost $160 in variable costs but
produce 140 bottles, the average variable cost for two workers is only
$160/$140=$1.14 per bottle.
Examining average variable costs (Cont’d)
• The decrease in average variable costs is the result of increasing
returns: the fact then when moving from one worker to two
workers, variable costs double (from $80 to $160) but output
more than doubles (from 50 bottles to 140 bottles).
• When diminishing returns set in, average variable costs start to
rise, which you can see as you move down the sixth column of
table 10-1. This happens because while each additional worker
costs an extra $80, each additional worker after the second
worker brings a smaller increase in output than his predecessor.
Each successive $80 wage payment brings with it fewer and
fewer additional bottles produced, so the average variable cost
per bottle must rise.
Examining average variable costs (Cont’d)

• LemonAid corporation’s average variable costs

show up as a subtle U shape when you plot
them on a graph, which I do in Figure 10-1. (I
also show the company’s average fixed costs
and average total costs.) Keep this average
variable cost curve in mind because it’s going
to have a huge effect on how many bottles the
firm’s managers want to produce in order to
maximize firm profits.
 Watching average fixed costs fall
• Average fixed costs (AFC) are defined as fixed costs
divided by quantity (FC/q). The fixed cost of LemonAid
Corporation are always the $100 it paid for the juicer
machine, no matter what amount of output it
produces. As a result, the more lemonade it produces,
the less average fixed costs are. That’s why AFC falls
(see the fourth column of Table 10-1) from a value of
$2.00 per bottle when 50 bottles are produced using
one worker down to only $0.21 per bottle when 470
bottles are produced using eight workers.
 Watching average fixed costs fall (Cont’d)

• Average fixed costs always decline, because

the same fixed cost gets divided up over a
greater and greater number of units of output
as output increases. When you plot out
average fixed costs per bottle, as in figure 10-
1, you get a downward sloping AFC curve.
Keep this fact in mind because it helps explain
the shape of the average total costs ( ATC )
curve which we will discuss next.
 The output of the firm under perfect
competition & maximization of profit
• We assume that the firm is in
business to make profits and
that it will aim to maximize
profits. As long as the price (AR)
it receives for each unit exceeds
the average cost of production,
the firm will be making profits.
Thus, in Fig. 19.4 (below) when
price = OP, the firm will be
making profits in the range of
output OQ to OQ3, because at all
outputs in this range, AR is
greater than AC.
 The output of the firm under perfect
competition & maximization of profit
• We have to determine which output between OQ and OQ 3 yields
the maximum profit. It should be apparent that output OQ 1 will
yield the maximum profit per unit, but firms seek to maximize
total profit not profit per unit. We notice first that as output
increases from OQ to OQ2 , the firm’s total profit will be increasing
because for each additional unit produced, the increase in total
revenue (i.e. MR) is greater than the increase in total cost (i.e.
MC). Remember that in this particular case, MR = AR.
• As output is expanded beyond OQ2, total profit will be
decreasing, because, for each additional unit produced, the
increase in total revenue (i.e. MR) is less than the increase in
total cost (i.e. MC).
The output of the firm under perfect
competition & maximization of profit
 The output of the firm under perfect
competition & maximization of profit
• Therefore since total profit is increasing up to OQ 2 and falling
beyond OQ2, profits must be maximised when output is at
OQ2, that is, when Marginal Revenue = Marginal Cost. It is
important that the explanation above is fully understood,
because the relationship which has been derived, i.e. profits
are maximised when output is at the point where MR = MC,
applies to all firms, whatever market structure they are
operating in.
• In the case of the perfectly competitive firm illustrated in Fig. 19.4
(above) demand is perfectly elastic so that AR = MR. Thus, in this
particular case, we can say that maximum profits will be earned
where AR = MR = MC.